Time to Do Your Homework

A few years ago when I first started writing about 13HF filings only a few of us tracked the portfolios of larger fund managers and hedge fund titans. Now, it seems everyone does and everyone is hoping to catch a ride on the stock picks of David Einhorn or John Paulson. Entire websites are devoted to cloning the portfolio of noted investors. I cannot imagine a more dangerous practice than blindly following a hedge fund's buying and selling activities. You will have enough losing stock ideas in your lifetime without taking anyone else's and without doing the homework.

When Paulson and Einhorn drop 30% or 40% in Bank of America (BAC) it means smaller fees for the year. When you and I do that we lose real money that is part of Junior's college fund or our retirement plan. You have no way of knowing if they shorted some options or even another stock against any given position. A purchase of a particular stock could be part of a capital structure arbitrage or the fund manager could have hedges in place that are not available to you and me.

The 13HF filings are simply a starting point to do the homework. If you find an interesting idea, dig in and make sure it fits your parameters as a long-term investment. I steal ideas from 13HF filings all the time, but I never buy without doing my homework first. The other useful activity I engage in each quarter is looking for trends in the buying and selling activities of the best of the best. If a bunch of managers are buying in a particular sector, or selling for that matter, I'll take note. If a lot of these talented individuals are buying a wide range of stocks in an out-of-favor sector, I'll look for the potential catalyst of things to change in that sector. I want to see which stocks they are buying at levels that fit my deep value, asset-based style.

A couple of trends have emerged this quarter. A lot of value and activist fund managers aggressively bought energy stocks; refiners attracted the most interest. As they pulled back, I saw a lot of buying in Tesoro (TSO), Valero Energy (VLO) and CVR Energy (CVI). David Tepper, Daniel Loeb and Joel Greenblatt have very different approaches to picking stocks, but they all bought the refiners on the selloff. I have a strong bias toward buying refiners close to 50% of tangible book value. They are not there yet, but if the global slowdown continues, they may well get there by year-end.

El Paso (EP) has attracted a lot of interest in the wake of its announcement that the company would spin off its exploration and production (E&P) company. The separation of the E&P business from the pipeline and transmission business could create higher valuations for both pieces of the company than they currently command as a combined entity. A diverse collection of successful investors, including Mario Gabelli, Michael Price and Leon Cooperman, seem to believe this will be the case as they purchased the stock in the second quarter.

Another noticeable trend in the quarter was that some of the super investors I follow are starting to buy little banks. Many of them were microcap and too small to write about here, but they key takeaway is that other investors are starting to edge into the trade of the decade. Many of these banks are incredibly cheap and their balance sheets are improving as the credit crisis works its way through the banking system.

One intriguing bank worth investigation is State Bank Financial Corporation (STBZ). The majority of the bank's loan portfolio is covered under a loss sharing arrangement with the FDIC. The bank carries the loans at around 60% of the outstanding principal balance, so any improvement in performance or recovery could have a material and dramatic positive impact on profits.

In spite of the well-known difficulties in financial stocks this year, both John Paulson and David Einhorn were buying shares of this bank. State Financial is very well capitalized, and if the shares fall below tangible book value of $11.57 a share, I would be a buyer. Now is the time to drag out your list of small banks and search for the very best bargains.

Banks and energy have been weak for the past few months, but many of the best investors are starting to buy in these sectors. It is probably time to start researching for your best ideas in these sectors.